Does your nonprofit owe income tax on multiple “silos” of unrelated business taxable income (UBTI)? This has been a difficult question for many tax-exempt organizations to answer due to the lack of guidance on what constitutes one unrelated trade or business, or one “silo.” On August 21, 2018, the Internal Revenue Service (“IRS”) issued Notice 2018-67 (“Notice”), providing interim guidance, and greatly needed clarity, on how to identify separate trades or businesses in connection with unrelated business income tax (“UBIT”) liability. This article provides six of the most notable take-aways from Notice 2018-67.
Background on UBTI Silos
In December of 2017, the Tax Cuts and Jobs Act (“Act”) added section 512(a)(6) to the Internal Revenue Code (“Code”), requiring that UBTI from each unrelated trade or business be calculated separately. Under section 512(a)(1), UBTI is defined as the gross income derived from any trade or business regularly carried on by a tax-exempt organization that is not substantially related to its tax-exempt purposes. Before the Act, tax-exempt organizations could aggregate the income, expenses, and other allowable deductions from all of its unrelated trades or businesses to calculate its tax liability. Under section 512(a)(6), a tax-exempt organization may no longer use the losses of one unrelated trade or business to offset the UBTI of another unrelated trade or business, causing many organizations to owe income tax for the first time. Prior to the Notice, however, there was no guidance on how to categorize unrelated business activities into separate trades or businesses or whether activities from the same types of trades or businesses could be aggregated.
Some of the confusion surrounding the new Code section relates to whether or not certain financial transactions that are not technically a “trade or business” will be subject to the new “silo” rules. These include debt-financed income under section 512(b)(4) of the Code, payments from controlled entities under section 512(b)(13), certain insurance income under section 512(b)(17), and certain employee fringe benefits under the newly-enacted section 512(a)(7). No guidance was provided on whether each type of statutory UBTI constitutes its own silo. For additional background, see our law firm’s article, The Changing Landscape of Unrelated Business Income Tax, published on August 15, 2018.
1. Reliance on a Reasonable, Good-Faith Interpretation
Section 3 of the Notice provides that a tax-exempt organization may rely on a “reasonable, good-faith interpretation” of section 512(a)(6) to determine whether it has more than one unrelated trade or business, including use of the fragmentation principle and the North American Industry Classification System (“NAICS”) 6-digit codes. The NAICS is a classification system already utilized on the Forms 990 and 990-T. The system groups together similar economic activities, or economic units, into defined industries that are identified using a 6-digit coding system. The NAICS is used by federal agencies to collect, analyze, and publish statistical data related to the U.S. business economy. Reliance on the NAICS provides a well-defined framework for grouping unrelated business activities together.
The IRS also noted in the guidance that the fragmentation rule set forth in section 513(c) and Treasury Regulation 1.513-1(b) may additionally be a prudent guide in the development of a nonprofit’s good-faith interpretation. The fragmentation rule provides that a tax-exempt organization’s business activity will not lose its identity as an unrelated trade or business merely because it is carried on within a larger aggregate of similar activities that are related to the organization’s exempt purposes. Before the Act, this principle was used to “fragment” the unrelated aspects of a trade or business from the related aspects. The classic example is the sale of jewelry in an art museum gift shop (unrelated) and the sale of postcards replicating the art in the museum (related). This same principle may now be helpful in identifying the scope of an “unrelated line of business” and the corresponding deductible expenses.
2. Treatment of Fringe Benefits
Section 8 of the Notice clarifies that the amount included in UBTI for certain employee fringe benefits as a result of section 512(a)(7) will not be subject to the silo requirement of section 512(a)(6). This was a helpful clarification from the perspective of siloing UBTI. However, many important questions continue to exist on the actual implementation and calculation of these new UBTI fringe benefit rules. Moreover, section 512(a)(7) continues to be the subject of a number of legislative repeal efforts currently proposed in Congress.
3. Treatment of Statuory UBTI
Section 4 of the Notice provides that the Treasury Department and IRS see no distinction between the income derived from an unrelated trade or business regularly carried on by a tax-exempt organization as set forth in section 512(a)(1) and the amounts included in UBTI as debt-financed income under section 512(b)(4), payments from controlled entities under section 512(b)(13), and certain insurance income under section 512(b)(17). The Treasury Department and IRS do, however, acknowledge the administrative burden associated with separately tracking and reporting UBTI from each debt-financed property or controlled entity and therefore provided that aggregating such UBTI “may be appropriate in certain circumstances.”
4. Aggregating UBTI From Investment Activities
Under section 5 of the Notice, the Treasury Department and IRS also acknowledge the administrative burden in separately calculating UBTI from certain investment activities, particularly with respect to ownership interests in multi-tier partnerships, and therefore plan to propose regulations treating certain investment activities as one trade or business for purposes of section 512(a)(6). This would allow the organization to aggregate the income and losses from such investment activities.
5. Interim Rule for Aggregating UBTI From a Qualifying Partnership Interest
If a tax-exempt organization holds a qualifying partnership interest that results in UBTI from multiple trades or businesses, it may be allowed to aggregate such UBTI under the interim rule set forth in Section 6 of Notice 2018-67. The interim rule provides that a tax-exempt organization may aggregate its UBTI from its interest in a single partnership, including any unrelated debt-financed income connected to such partnership interest, if it meets the de minimis test or control test.
- The de minimis test allows a tax-exempt organization to aggregate its UBTI from its partnership interest if the organization holds no more than 2% of the profits interest and no more than 2% of the capital interest of the partnership.
- The control test allows a tax-exempt organization to aggregate its UBTI from its partnership interest if the organization holds no more than 20% of the capital interest and does not have control or influence over the partnership.
6. Transition Rule For Aggregating UBTI From a Qualifying Partnership Interest
The Treasury Department and IRS acknowledged in the Notice that it may be difficult for a tax-exempt organization to modify its partnership interest to meet the de minimis or control tests so it provided a transition rule allowing an exempt organization to treat a partnership interest acquired prior to August 21, 2018, as a single trade or business under section 512(a)(6), regardless of the actual number of trades or businesses conducted by the partnership. Similar to the interim rule described above, any unrelated debt-financed income connected to the partnership interest may be aggregated with other UBTI resulting from the same partnership interest.
While the Notice is not exhaustive and leaves some questions unanswered (e.g., how to calculate UBTI from fringe benefits), it certainly provides helpful interim guidance in navigating some of the complexity and uncertainty of section 512(a)(6). In particular, the Notice allows the use of the fragmentation principle and NAICS 6-digit codes to assist in classifying business activities into separate trades or businesses. It also allows tax-exempt organizations to aggregate qualifying partnership interests under the interim rule and transition rule, and it at least acknowledges the need for aggregating some statutory UBTI and UBTI from certain investment activities. As the Treasury Department and IRS continue to seek comments from the public, the nonprofit sector continues to wait for the forthcoming proposed regulations in hopes that it will provide additional clarity and guidance.